Internalising climate change externalities: leading by example

Climate change and climate-related events can have profound consequences for society, the economy and business. Coping with these externalities does not depend solely on government initiative. The decision of the private sector to take them into account when buying or producing—internalising them—can make a big difference.

Assets as a collection of macro-factor exposures

Equities, bonds, real estate… all assets provide exposure to different macro-factors. This exposure will determine the asset’s return. Macro-factors include growth, earnings, inflation, rates, etc. Other variables are relevant in determining an asset’s price, but in general they can be linked to broader top-down factors. Investor risk-appetite influences pricing, but in turn depends on the level of interest rates, the cyclical environment as well as psychological factors. Asset owners and financial intermediaries (banks, portfolio managers, etc.) rightly spend a lot of time analysing the expected evolution of these macro-factors.

Climate change as a full-fledged macro-factor

In recent years there has been growing awareness that climate change should be considered as a macro-factor as it can have profound consequences for society, the economy, business—and hence asset values. Governments may be expected by citizens to step in following climate-related catastrophic events or to take pre-emptive measures against the risk of flooding, for example. Contingent liabilities may be triggered, putting a burden on government finances and recent research by the Bank of England has shown how climate events can influence monetary policy.

Given the potential long-term consequences of global warming and the event risk of climate-related shocks, considering climate change as a full-fledged macro-factor has become a fiduciary duty. The focus of this duty should be on risk analysis, because climate change as a business opportunity can be incorporated in the analysis of traditional economic factors (expected growth). This risk-only focus makes climate change special compared with other macro-factors.

Another specificity of climate change as a macro-factor is the presence of externalities. When your neighbour organises a barbecue but forgets to invite you, you suffer from an externality: you’re exposed to the smoke and the smell without being able to enjoy the food. Externalities lead to mispricing (carbon emissions are not reflected in the price of goods) and an underestimation of investment return. When a household installs solar panels, it will tend to focus on its own return on investment rather than the positive externality to which it makes a (small) contribution. Society at large would benefit if households and companies all try to reduce their footprint: the ensuing reduction in climate risk would increase the return of investment in the aggregate. Underestimation of the return on investment will lead to underinvestment—and hence missed opportunities.

Public sector initiative to address externalities

Whereas considering climate risk as a macro-factor when valuing assets is a fiduciary duty, incorporating the externalities of climate change in decision-making should be a moral obligation. Most would agree that the wellbeing of today’s generation (economists would call this “utility”) also depends on the expected wellbeing of future generations. Economic decisions are taken within a multi-period framework (“should I invest today or tomorrow?”) so it would be strange not to apply this thinking to climate change. In view of the complexity in assessing the long-term consequences of externalities, there may be a reaction to rely exclusively on governments to address this issue. Governments can intervene by creating awareness, influence behaviour via subsidies, taxes and regulation (think of carbon-emission rights). The Paris Agreement (COP21) of 2015 provided a breakthrough in this respect.

Private initiative to address externalities

The announcement by Donald Trump on June 1 this year that the US would withdraw from this accord was met with disappointment, but interestingly many US companies reacted by saying they would continue to reduce their environmental footprints. This reminds us that private initiative has a key role to play in addressing the climate-change challenge by internalising the climate change-related externalities of their decisions. If households become more environment-conscious, their spending patterns will change, forcing companies to adapt. These companies may adapt proactively to the prospect of more environment-aware buying behaviour. “Buying” covers more than goods and services. It also encompasses capital expenditures and financial investments. Similarly, “supply” covers the production of goods and services as well as the issuance of debt and equity. The opportunities on the supply side to internalise externalities are huge. Companies can strive to reduce their operational footprints, not only because they consider it a moral duty, but because they expect to be questioned on it by customers. In addition, they can reduce the footprint of their goods and services and benefit from expected changes on the demand side, but also because they expect that, for example, investors, will increase their focus on the environmental footprints of the companies they invest in. This applies to the financial sector, too (bank lending policies or the investment policies of insurance companies). To this end, communication and transparency play a key role, because they facilitate environmental assessment by the buy-side. Product-level communication is essential in the absence of carbon pricing: adding a carbon-intensity label (“green, orange, red”) to a price tag would provide the customer with some feel for the externality of his buying behaviour.

On the buy-side, procurement can become a driver of change for the supply side by incorporating environmental-footprint questions in tender offers. This approach is also applicable when asset owners invest in mutual funds or delegate portfolio management to a manager. Asset owners can lead by example by incorporating environmental, and more broadly, SRI criteria into their investment decisions—and communicating it. There is a great opportunity for institutional investors to agree on a scale reflecting the SRI content of their portfolios and investment process. Such an approach would foster a race to the top among institutional investors that would also create positive externalities welcomed by the entire planet. It is one illustration that coping with externalities does not depend solely on government initiative. The decisions of the private sector to take them into account when buying or producing—internalising them—can make a big difference.